Here's All You Need To Know About China's Fragile $2.2 Trillion Shadow Banking System

Given that, guarantors are turning to illegal practices in order to boost their returns. Cui surmises that "the biggest risk in the industry is guarantors are acting more like a lender rather than focusing on their core guarantee business."

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What do the guarantors do to make money instead? They literally take a portion of the loan they are guaranteeing from the borrower they are guaranteeing and lend that money back into the shadow banking system to other underground borrowers. The net effect, of course, is amplified leverage within the shadow nexus.

And that is how the loan guarantee business in China really gets wild – instead of providing guarantees on clients' loans, guarantors themselves are taking the loan money they are guaranteeing and lending it out to even riskier borrowers.

Bottom line: When those new shadow loans blow up (potentially due to any of the four triggers mentioned at the beginning of this article), it is the clients – who are supposed to be guaranteed by the guarantors in the first place – that end up footing the bill.

And the big worry is that this has already begun. Two guarantors, for example – Huading and Chuangfu – have already run into trouble. Cui writes that "many of their clients have been sued by their banks for loan repayments although the borrowers claim that their guarantors have been using the fund," and that "some of these borrowers are now seeking help from the municipal government of Beijing...to negotiation for a loan extension with the banks."

Shadow banking entity #4: Underground banks

Cui calls underground banks "arguably the most unstable shadow banking sector". And the commodities business is currently a major player in this area.

Letters of credit – trade finance agreements in which a bank pays the seller of a commodity and then goes and collects payment from the buyer of the commodity – are booming, and they are off-balance sheet vehicles, meaning they don't factor into the traditional banking sector's balance sheet leverage ratios and regulations regarding loan quotas.

Cui points out that many of the companies that are shut out of the official loan market are resorting to securing letters of credit from banks using copper and other commodities as collateral.

And metals traders are getting in on the game, too. A trader will borrow to buy copper or steel via a bank who issues a letter of credit to the seller on behalf of the trader. The trader can then take his new metal stock and pledge that as collateral for a normal bank loan, which he can then take and make money by lending the funds back into the shadow banking market at a higher interest rate.

When it comes time to for the trader to cover the letter of credit several months later, he recalls the loan from whoever he lent it to and pays back the bank.